Audit Firm Tenure and Audit Quality in a Constrained Market

We examine the relation between audit quality and audit firm tenure in the Iranian audit market, which is constrained by government policies that create intense competition for clients among many small audit firms. We develop arguments that these circumstances create cost pressures that entrench low audit quality and render auditors’ plans more predictable to managers wishing to misstate their accounts. Using publicly available data for the audits of listed companies in Iran prior to mandatory audit firm rotation and the incidence of misstated financial reports identified by the Iranian Association of Certified Public Accountants Inspection Office, we find that the likelihood of a misstatement is lowest in the first two years of audit firm tenure. We also find that the likelihood of misstatement is not associated with the year preceding a mandatory audit firm rotation, suggesting outgoing auditor effort is not sensitive to the prospect of subsequent revelations of deficiencies. Although our results from a pre-mandatory rotation period show that frequent rotations appear to improve the financial reporting quality in our sample, we are wary of interpreting these results as support for the mandatory audit firm rotation policy in Iran. Rather, we suggest this is a peculiar consequence of deficiencies in audit quality inherent in the Iranian market.

Introduction

This paper examines the relation between audit firm tenure and audit quality in the Iranian audit market. The effect of audit firm tenure on audit quality, and thus on the quality of financial reports, has been the subject of a long debate among professionals and regulators. Regulators around the world have considered mechanisms aimed to improve auditor independence, including mandatory auditor rotation at both the partner and firm level (Firth, Rui, & Wu, 2012). Proponents of mandatory audit firm rotation emphasize the auditor independence hypothesis to argue that audit quality tends to decline with audit firm tenure because longer tenure can increase economic dependency on the client (DeAngelo, 1981; Raghunathan, Lewis, & Evans, 1994), induce auditor complacency (AICPA, 1992; GAO, 2003; Johnson, Khurana, & Reynolds, 2002; Shockley, 1981), and increase familiarity threats to auditor independence (AICPA, 1992; Arel, Brody, & Pany, 2005). By limiting tenure, mandatory audit firm rotation can reduce the likelihood of economic dependency, familiarity, and complacency (Mautz & Sharaf, 1961). Opponents of mandatory audit firm rotation refer to economic bonding arising from fee dependence to argue against mandatory rotation. To the extent that auditors low-ball audit fees (DeAngelo, 1981), audit firms are more likely to accede to their clients’ demands in the initial years of tenure for fear of threats of dismissal and loss of future quasi-rents(Geiger & Raghunandan, 2002). Thus, as audit firms earn those quasi-rents with increase in tenure, they are more likely not to acquiesce to clients’ demands in the later years of tenure, which may tend to increased audit quality (Arel etal., 2005). Also, it is argued that audit quality tends to increase with audit firm tenure because the auditor gains a better understanding of the client’s systems, internal controls, business, and industry environment (Beck, Frecka, & Solomon, 1988; Geiger & Raghunandan, 2002). However, both sides of the audit firm rotation debate are predicated on assumptions regarding institutions and market conditions that attach substantial value to auditor independence and competence. These assumptions might not hold for immature audit markets where supply and demand conditions do not encourage or facilitate auditor independence, auditor competence, audit effort, or auditors’ investments in improving audit quality. Low investments in training, licensing, and oversight of auditors; the absence of sufficiently strong market mechanisms that reward or punish differences in audit quality; and limited audit firm resources may result in low levels of auditor independence or otherwise impede audit quality regardless of audit firm tenure.